Do Tax Cuts Stimulate the
Economy?
by
James Kroeger
In order for us to understand the
ultimate impact that income tax cuts have on the welfare of
taxpayers, we need to understand their effect on both the purchasing
power of individual taxpayers and the effect they have on the
economy's aggregate supply. These are two separate effects
that overlap each other, but it is possible to isolate their
independent effects. The impact that an income tax cut has on the
purchasing power of taxpayers (they gain nothing) is
something that I address in another article. In this essay I
want to discuss the impact that a tax cut can have on the Supply
Side of the economy, i.e., on the total amount of goods & services
that the economy produces.
One important lesson that economics
students learn when they are first exposed to macroeconomic theories
is that producers and retailers are strongly influenced by aggregate
demand. Assuming nothing else changes, an increase in
aggregate sales (expressed aggregate demand) generally prompts
suppliers to produce and bring to market more goods &
services. If it appears you can sell more, it makes sense for you
to produce or obtain more product to meet increasing demand. Thus,
if we want to understand the ultimate impact that across-the-board
income tax cuts have on the supply-side of the economy, we will need
to understand how they affect aggregate demand.
It is no surprise that income taxes
deprive taxpayers of some of the money that they would otherwise
have spent on consumption. If this reduction in consumer spending
was the only consequence of taxation, we'd be forced to
conclude that tax increases always have a negative impact on the
health of the economy. Why? Because any time money is spent
in the economy, it becomes someone's income (wages, profits). All
incomes are dependent on the spending of others. When aggregate
spending drops, there is less money available to pay those incomes,
so people lose their jobs. Spending must occur in order for
people to have jobs.
But there is more to the story. The
only reason why governments collect tax revenue from citizens is
in order to spend it. When governments spend money, it
automatically becomes income to a large number of citizens.
So instead of causing aggregate spending to drop, an increase
in tax rates actually causes it to increase. Why? Because some of
the money that people receive as income from the government---that
was originally obtained from taxpayers---would have been saved,
if certain taxpayers (typically wealthy ones) had not used it to pay
their taxes. When the government collects & spends money
that would have been saved, it is pumping money into the
economy that would otherwise have been removed from it.
This can be a very desirable outcome if
your country is suffering from any kind of unemployment. The act of
saving money may not be egregiously harmful to the economy most of
the time, but it can do an incredible amount of damage if it “gets
out of hand.” The Great Depression, for example, occurred for one
very simple reason: those who had money that they could have
spent chose to save it instead, denying people jobs. Those who
would have been happy to spend that money did not have it in their
possession. It is a reality that economists summarize in the
equation: income = savings + consumption (spending).
This relationship between spending,
saving, and jobs is important. The only reason why there is ever
any unemployment is because too much saving takes place. The
only way it has ever been possible to reduce unemployment is through
the increased spending of either individuals or firms or
governments. When can we say that an economy has finally achieved
its optimal level of savings? Answer: when there is no
unemployment. When can we say with certainty that there is too
little saving taking place in an economy? Answer: when the
economy is booming, there is no unemployment, and hyperinflation is
threatening. Only then will an increase in net savings
not threaten jobs.
Advocates of Supply-Side economics have
apparently never realized that when they recommend across-the-board
income tax cuts and matching reductions in government
spending, they are proposing a policy that---all else equal---is
guaranteed to either cause a recession or make any ongoing
recession worse. Across-the-board income tax cuts are
contractionary (assuming matching spending cuts) because
wealthier recipients of income tax cuts will save some of the extra
disposable income they are given. Since not all money that is saved
is lent out to borrowers, there is a net leakage of money out of the
economy whenever money is saved.
Tax cut enthusiasts like to refer to tax
cuts as though the incomes of other people are not dependent on the
money that would be returned to taxpayers. They suggest, instead,
that everyone's tax money ends up being sucked into a powerful Black
Hole known as Big Government where it disappears forever. The truth
they ignore is that even if an income tax cut were designed to
give refunds only to people who would be certain to spend all of it
(poor people), it would still not provide any net stimulus to
the economy. When spending-cut-dollars match tax-cut-dollars, the
money that refunded taxpayers would get to spend would have been
spent by the federal government anyway. This means that
no net increase in aggregate spending can occur, so there is no net
increase in jobs or incomes.
A fiscal policy initiative can properly
be described as expansionary only if it ends up increasing
total spending in the economy. Tax cuts by themselves cannot do
that. In spite of this fact, nearly every introductory economics
textbook in America today mentions tax cuts as one of the
federal government's expansionary fiscal policy tools and
fails to mention that tax increases are far more
effective than tax cuts in stimulating the economy when the money
that is collected in taxes would have otherwise been saved. One
unfortunate consequence of this educational failure is that we now
have politicians in charge of America's federal government who have
cut taxes repeatedly over the past few years in the mistaken belief
that they would stimulate the economy.
The only reason why the Bush Tax Cuts
did not plunge the economy into an even deeper recession is because
the federal government increased its spending after
Nine-Eleven using borrowed money to finance it instead of tax
revenue. Unfortunately, the stimulative effect of this increased
spending was largely offset by the contractionary effect of the tax
cuts. Giving the largest share of a tax cut to rich people who are
most likely to save a great deal of it is not a very intelligent
thing to do when the economy is struggling to pull out of a
recession. The result has been a sputtering and long overdue
'recovery' that has created far fewer jobs than almost any economic
recovery in American economic history in spite of the added benefit
of historically low interest rates.
We are currently witnessing yet another
failure of Supply-Side tax policy to produce the results that its
advocates have always cheerfully predicted. Their vain hopes have
been driven by an almost theological belief that increases in
aggregate savings will lead directly to increases in investment
spending. Many economists have encouraged acceptance of this
presumed causal relationship because they've understood that---if
true---such a premise would provide them with the ultimate
justification of their constant efforts to reduce the tax burden of
rich people. With it, they've been able to depict an activity that
can be very damaging to the economy (saving money) as something of a
Supreme Economic Virtue. Unfortunately, very little of this wishful
thinking is true...
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Related Economic Analysis:
MAKE
THE AMERICAN PEOPLE RICHER
THE MISUNDERSTOOD RELATIONSHIP
BETWEEN SAVINGS & INVESTMENT
ARE INCENTIVES NEEDED TO
ENCOURAGE INVESTMENT?
ECONOMIC
POLICY
MEASURING SAVINGS AND
INFLATION
